The Value of Strategic Oil Stocks Under Reduced U.S. Oil Imports

1. The Value of Strategic Oil Stocks Under Reduced U.S. Oil Imports Paul N. Leiby*, David Bowman**, Gbadebo Oladosu*, Rocio Uria-Martinez*, Kenneth Vincent*** *Oak Ridge National Laboratory, **Econotech, ***U.S. Dept. of Energy Presented at the meeting of the U.S. Association for Energy Economics, July 29, 2013

2. 1. Context and Objective • Changing oil marketconditions and expectations • Increases in tight oil production in U.S. • Decreasing consumption and imports of oil • Interest in implications for U.S. oil security • Strategic petroleum reserve benefits • Response to severe global and local shocks • Avoided GDP losses • Reduced oil import expenditures • Evaluate how major increases in U.S. oil production will change benefits of oil stocks to U.S. • Paper does not advocate any particular policy course of action, it speaks to contemporary debates.

3. Outline – rest of talk • Context and objective • Approach (method and assumptions) • Results • Comparison of world views: AEO2010 vs. 2013 • Alternative future cases • Sensitivity to assumptions • Conclusions • Key insight(s) • Limitations, Outstanding Issues for Future Work

4. 2. Approach • Simulation model to quantify benefit of emergency stocks, with disruption • Focus on global crude oil supply shocks • Economic benefits are quantified in terms of avoided GDP losses and import costs • Compare benefits of stocks in different cases • coordinated use of U.S./IEA emergency stocks

5. Benefits of Emergency Oil Stocks: Simulation Framework • Various reference world oil market conditions compared. • Storage sizes, capabilities characterized • 30 year time horizon Monte Carlo simulation, including the possibility of disruptions (generated using EMF probabilities). • Economic Benefits of storage and drawdown estimated.

6. Model Features and Inputs • Disruption risks (event sizes, durations, probabilities) • Based on EMF/Huntington/Beccue 2005 • Price determination during shocks • Market demand responses – short & long-run elasticities • higher range -0.11 to -0.25 annual elas., depending on disruption • lower range -0.05 to -0.19 (Dargay & Gately 2010) • GDP responses to prices • Estimated range, based on prior studies and review of recent literature (range -0.0316 to -0.0086, Mean -0.024, for U.S.) • Other Data Sources • Global oil market projection based on EIA Annual Energy Outlook (AEO) • base, undisrupted prices, supplies, demand, capacities, imports • Stock levels: IEA

7. Market Factors that Influence Stock Benefits under Increasing U.S. Oil production in the United States • Domestic production levels • Consumption levels • => Import levels • Reference prices • World oil supply at risk • Spare production capacity (global) • GDP growth rates

8. U.S. Liquid Fuels Net Imports

9. World Oil Prices

10. OPEC Liquid Fuels Supply

11. In AEO2013, new supply sources diminish global reliance on risky supply

12. OPEC Spare Capacity • Consistent with OPEC statements and some DOE projections: assume target ~2.8 MMBD • In cases where OPEC supply declines, assume spare capacity expands, but trends back to target over 10 years.

13. IEA Max Drawdown Rate as a Function of Size for Year 2013

14. 3. Results • Results calculated and presented in terms of benefits timepaths, NPV and average dollar benefits per barrel per year, with confidence intervals • Includes a reference case as well as sensitivity cases with different potential levels of U.S. oil output, consumption and imports • Other benefits that are potentially important but more difficult to quantifynot included

15. Annual U.S. Benefits of Emergency Oil Stockpiling: Implications of Evolving World View (AEO2010 vs AEO2013 Base) Undiscounted time stream

16. Annual U.S. Benefits of Emergency Oil Stockpiling: AEO2013 Higher and Lower U.S. Resource Cases (with Base) Undiscounted time stream

17. U.S. Benefits of IEA Emergency Oil Stockpiling, Higher Demand Elasticities Discount Rate 7% NPV over 2013-2043

18. U.S. Benefits of IEA Emergency Oil Stockpiling, Lower Demand Elasticities Discount Rate 7% NPV over 2013-2043

19. Sensitivity Cases with Uncertainty Ranges(Annual U.S. Benefits per Barrel of Emergency Stockpiling, Variations on AEO2013 Base Outlook) Non-U.S. IEA Stock Availa-bility(Base: 100%) Saudi Arabian Spare Capacity (base=50%) Drawdown Threshold (Base: 2 MMBD) Obligated Industry Stock Availability (Base: 100%) Sensitivity of GDP to Oil Price SR Price Elasticity of Demand Base Undiscounted U.S. Benefits in $/BBL/Yr of U.S. Storage. Higher demand elasticities case.

20. 4. Conclusions • Shock costs (& stock benefits) decrease with U.S. Imports, but not completely • Core conclusion: • While wealth transfer caused by oil shocks is much-decreased in some futures, • The GDP impact of oil shocks could still prove greatly harmful so long as U.S. is major oil consumer and integrated with global market • Other unquantified benefits strategic oil stockpiles such as the deterrent capability and added foreign policy freedom that they give to importer governments, arguably unchanged by imports • Sensitivity of these results • Short-run demand elasticity and GDP sensitivity to shock • Level of global spare oil production capacity • Threshold at which drawdowns are initiated

21. Limitations, Outstanding Issues for Future Work • Problems with understanding spare capacity, supplier risk • Need for renewed examination of global disruption risks • Importance of how market flexibility, and GDP sensitivity to shocks, may be evolving • Consider evidence of declining demand elasticities • Hard to understand short-run elasticities for potential unprecedented large disruptions, emergency conditions • Still need for further study of how macroeconomic sensitivity to oil shocks may be changing

22. Thank You!leibypn@ornl.gov

23. Supplementary Slides

24. Recent Arguments that Oil Demand Becoming More Inelastic • Related work e.g. by Hughes et al., 2008; Dargay&Gately, 2010; Baumeister and Peersman, 2011 • Multiple explanations are offered for this trend: • The low hanging fruit (of energy conservation/substitution) already picked • Becomes more difficult to reduce quantities demanded as prices increase. • Elimination of large amount of dual-fired electric generation capacity, Low fraction used in electricity generation • Increased/increasing fraction of oil consumed by non-OECD countries • non-OECD countries are (or, at least, have been until now) more inelastic than OECD • Increased/increasing fraction of oil consumed in the transportation sector • more inelastic than the average elasticity across all uses (Dargay and Gately, 2010) • As transportation fuel efficiency increases, less fuel-price-elastic (Hughes et al., 2008) • Changes in the way oil trading is conducted. (Baumeisterand Peersman, 2011) • Complex interplay between the supply and demand sides of the market: • OPEC producers realized in the 80s that demand had become less responsive, slowed capacity additions • Give shrinking spare capacity, consumers become more risk averse, precautionary demand increases (Baumeister and Peersman, 2011)

25. Update on compiling oil price-GDP elasticities: Surveyed recent literature, focused on 13 applicable studies • Alessandro Cologni and MatteoManera (2008) Oil Prices, Inflation and Interest Rates in a Structural Cointegrated VAR Model for the G-7 Countries. Energy Economics 30 (2008) 856–888 • Makena Coffman (2010) Oil price shocks in an island economy: an analysis of the oil price-macroeconomy relationship. Ann RegSci (2010) 44:599–620 DOI 10.1007/s00168-008-0271-6 • Marcelo Sánchez (2011) Oil shocks and endogenous markups: results from an estimated euro area DSGE model. Int Econ Econ Policy (2011) 8:247–273 DOI 10.1007/s10368-010-0159-7 • Surender Kumar (2009) The Macroeconomic Effects of Oil Price Shocks: Empirical Evidence for India. Economics Bulletin 29(1): 15-37 • Luis J. Álvarez, Samuel Hurtado, Isabel Sánchez, Carlos Thomas (2010). The impact of oil price changes on Spanish and euro area consumer price inflation. Economic Modelling 28 (2011) 422–431 • Lutz Kilian. A Comparison of the effects of exogenous oil supply shocks on output and inflation in the G7 countries. Journal of the European Economic Association 6 (1): 78-121 • LeventAydin, MustafAcar. Economic impact of oil price shocks on the Turkish economy in the coming decades: A dynamic CGE analysis. Energy Policy 39 (2011) 1722–1731 • LiminDua, Yanan He, Chu Wei. The relationship between oil price shocks and China’s macro-economy: An empirical analysis. Energy Policy 38 (2010) 4142–4151 • GertPeersman, Ine Van Robays. Cross-country differences in the effects of oil shocks. Energy Economics xxx (2011) xxx–xxx (In Press) • Christian Lutz, Bernd Meyer Economic impacts of higher oil and gas prices: The role of international trade for Germany. Energy Economics 31 (2009) 882–887 • IikkaKorhonen, Svetlana Ledyaeva. Trade linkages and macroeconomic effects of the price of oil. Energy Economics 32 (2010) 848–856 • Katsuya Ito. The Impact of Oil Price Hike on the Belarusian Economy. Transit Stud Rev (2010) 17:211–216 DOI 10.1007/s11300-010-0140-8 • Ana Gómez-Loscos, Antonio Montañés, M. Dolores Gadea. The impact of oil shocks on the Spanish economy. Energy Economics 33 (2011) 1070–1081

26. Study Data Covers mostly OECD economies • Estimates were annualized • Substantial variation across studies and regions

27. Explored Extrapolation of Study Estimates to Other Countries/Regions on Basis of Determinants of Vulnerability • Regressed GDP elasticities from study results against commonly hypothesized indicators of country vulnerability: • Energy intensity of GDP (Energy/GDP) • Oil intensity (Oil Consumption/Energy consumption) • Oil imports (Oil Imports/Oil Consumption) • These indicators can only partially explain variations in estimated GDP elasticities, not surprisingly • R2 ~50% • Weak significance (except Oil intensity) • Relationship may be explored further, but current version provides guidance for adjusting average IEA elasticities to Non-IEA.

28. Oil Intensity of U.S. GDP

29. EMF 2005 Semi-Continuous Disruption Probabilities

30. EMF 2005 Discrete Disruption Probabilities

31. which gives us or constant levels. Basis for Excess Capacity Assumptions • IEA, EIA, is consistent with other estimates • "Saudi Arabia will continue with its current plan to maintain spare production capacity at levels between 1.5 and 2.0 million barrels per day." EIA's International Energy Outlook 2011, p. 35 • "'Given that the kingdom has total production capacity of 12.5 million b/d, of which 72% is currently being exploited, actual production to end 2030 will be maintained at this assumed level within this available capacity,' he added. 'This will be enough to meet anticipated production [requirements] while maintaining through this period spare capacity that will reach 1.7 million b/d by 2030, within the kingdom's declared aim of maintaining spare capacity of 1.5-2 million b/d,' Moneef said." Platts - 2011

32. U.S. Liquid Fuels Supply

33. U.S. Liquid Fuels Demand

34. Annual U.S. Benefits of Emergency Oil Stockpiling: AEO2013 High and Low Oil Price Cases (with Base) Undiscounted

35. U.S. Benefits of IEA Emergency Oil Stockpiling are Asymmetrically Distributed(Mean and 95% Confidence Interval, AEO 2013 Base Case)

36. Variant Studies: Cost Benefit Analysis Crude Mix, Regional Oil Stocks, and/or Product Reserve • General idea is to consider relative merits of • Crude Oil Stocks in U.S. Gulf region • Heating Oil Stocks in Northeast • Gasoline Stocks in West Coast, or inland from Gulf Coast • Alternative Regional Energy Security measures • For Crude oil stocks, a related question is “Crude Mix” • Past ICF and ORNL studies indicated refinery flexibility sufficient to accommodate wide crude mix, but these conclusions may no longer be valid • Regional Petroleum Product Reserve • Early 1990s ORNL“RPPR” Study highlighted distinct economic and risk implications of regional product stocks • 1997 revisitation • Major new study completed 2010-2011 focusing on Hurricane risk

37. 2011 RPPR Study: Assess the need for a Southeast Refined Petroleum Product Reserve to address hurricane related product supply shortages. Gulf Coast Refinery Outages (Category, Ref. Proximity) Product Price Increases (With and Without RPPR) GDP Losses Hurricane Activity (Number, Timing, Category, Landfall location) Analysis For Each Hurricane Season Gulf Coast Hurricane Vulnerability Expected Reduction in GDP Losses over 30 Years for 30 MMB RPPR by Region Study Conclusion: Analysis supported a reserve of at least 30 million barrels.

38. Stockpile Benefits Spillover, But “Public Good” Analogy is Inadequate • Spillover means some “Global Public Good” properties • But many benefits, e.g. import cost savings and particularly non-economic and indirect benefits, flow to stock owners • Use care, Some game-theory analogies poor • E.g. “Common property” and “Prisoners Dilemma” • “Access” (stock use) not guaranteed • Cooperating means sharing in drawdown decision • “Free-riding” (non-cooperation) not a good strategy. • Can show: • Gains of Free Ride much less than Losses if No Ride is provided

39. Summary: Insights from Past Single-country and Cooperative Stock Analyses • Oil Market is Unstable, and Oil Shocks Matter • True for essentially all world consuming regions • Economic value to stock expansion for many large regions • Benefit-payoff structure supports (in some cases, requires) collaborative stockpiling initiatives. • Collective groups of countries sharing a reserve prefer larger size and • achieve greater benefits than the sum of individual countries acting alone • Longer run demand reduction and flexibility worthwhile • Diplomatic actions and relations are critical

40. Main Assumptions • Disruption Risks • EMF/Huntington/Beccue 2005 • Demand Elasticities • GDP response to prices • Estimated range, based on prior studies and review of recent literature (range -0.0316 to -0.0086, Mean -0.024) • Excess capacity ~2.8 MMBD • Drawdown threshold: 2.0 MMBD

41. Annual per Barrel U.S. Benefits of Emergency Stockpiling for a Variety of Sensitivities • Sensitivity to GDP Elasticity w.r.t. Price • An important sensitivity, Base case assumes triangular distribution based upon meta study. • Price Elasticity of Demand • Also important. Base case from Dargay and Gately (2010). Several studies points towards recent move to oil demand being more inelastic. • Saudi Arabia Spare Capacity • Uncertainty surrounds size and likely of Saudi drawdown. Increase in draw % reduces the need for reserves and therefore the benefits. • Drawdown Threshold • Base assumes all net disruptions above a hypothetical 2 MMBD threshold addressed if possible. Raising draw threshold increases exposure to smaller but more numerous and still damaging disruptions. Lowering the threshold results in more frequent intervention. • IEA Obligated Industry Stocks • Assumed to be ~800 MMB and capable of very fast drawdown. Diminishing returns to emergency stocks means that increasing availability is less beneficial than damage from reducing it. • Non-U.S. Emergency Stock Availability • U.S. acts alone. Loss 1,300 MMB Non-U.S. IEA stocks (Public + Available Industry Stocks) results in loss of spillover benefits and reduced ability to cover disruptions in terms of both size and length.

42. Evolving Demand Elasticity and Market Responsiveness [???draft] • Factors cited for declining demand elasticity (e.g. Hughes et al., 2008; Dargay and Gately, 2010) • xxx • Possible sources of increasing demand elasticity • Dahl’s cross-country comparison finds gasoline demand elasticity increases with price and with income (diesel, she elasticities decrease with income) • A significant increase in dual/flex-fueled vehicles (e.g., FFVs, PHEVs) could be another mechanism for increasing oil demand elasticity • Note IMF 2011 annual elasticity value • World oil demand elasticities Frequency of data used Period of analysis Oil demand elasticity • Dargay and Gately (2010) plus IEO 2011 Annual 1971-2008 -0.24 (constructed value for elasticity in production 2013) • Baumeister and Peersman (2011) Quarterly 1974-2010 -0.1 (estimated posterior median for elasticity in production 2010) • -0.26 (average posterior median for elasticity in production 1974-2010) • show notably declining demand elasticities in recent years (about -0.1 in 2005-2010) • Killian and Murphy (2012) Monthly 1973-2008 -0.26 (posterior median for elasticity in use for 1973-2008)[1] • Plenty of support for the idea of decreasing elasticities over the last few decades • Alternative view from recent Killian and Murphy 2012 paper is an outlier • Baumeister and Peersman (2011) uses similar approach focusing on time-varying elasticity, and show notably declining demand elasticities in recent years (about -0.1 in 2005-2010)